Related Party Transaction: FAQs

Published on Tue, May 13,2014 | 23:15, Updated at Tue, May 13 at 23:15Source : Moneycontrol.com

By: Pankaj Chadha, Partner-Member Firm, EY Global

Transactions with related partiesTransactions with related parties are of vital interest to majority and minority shareholders alike and it is important that the interests of shareholders as a whole are fully protected especially when control of the company or the Board resides with a single party. Many related party transactions are in the normal course of business. In such circumstances, they may carry no higher risk than similar transactions with unrelated parties. However, the nature of related party relationships and transactions may, in some circumstances, give rise to higher risks of abuse than transactions with unrelated parties. For example, related parties may operate through an extensive and complex range of relationships and structures, with a corresponding increase in the complexity of related party transactions; related party transactions may not be conducted under normal market terms and conditions (for example, some related party transactions may be conducted with no exchange of consideration).

While the great majority of related-party transactions are perfectly normal, the special relationship inherent between the involved parties creates potential conflicts of interest which can result in actions which benefit the people involved as opposed to the shareholders. Not all RPTs are beneficial to investors. Though they are not illegal, the intricacies underlying them are difficult to identify. RPTs include granting loans, writing off loans and dues, selling assets to a related entity for a price significantly below the market price, and so on. Such RPTs are usually indulged in by dominant shareholders, who have significant control rights compared to their cash flow rights, creating a strong incentive to expropriate the minority shareholders. Many high-profile accounting frauds in recent years (such as Enron in US and Satyam Computers in India) have involved RPTs in one way or the other. Adverse RPT reduces transparency in reporting, decreases the value of the firm, and stunts the growth of the capital markets ultimately.

All RPTs, are not abusive. A related-party transaction can also play a beneficial role by saving transaction costs and improving the operating efficiency of a company. In fact, there maybe several such transactions that are unavoidable because they make commercial sense for the company; if companies are prohibited from entering into such transactions, it might work against the principle of maximising the shareholder value. For example, many multinational companies operating outside their parent countries have business models that involve RPTs. The parent companies bring in technology and know-how as well as financial assistance to the subsidiaries as and when needed.

In this context, it may be useful to highlight the key RPT Regulations in the U.S. Under the Sarbanes Oxley Act 2002, public companies are prohibited from making or arranging for personal loans to any director or executive officer. The NASDAQ also requires that the audit committee or another committee of independent directors reviews and approves all RPTs. Further, the Securities Exchange Commission (SEC) requires a disclosure of transactions in excess of USD 120,000 in which a related person, has a director indirect material interest. There is no requirement in the U.S. for shareholder approval of RPTs as in India. However, the U.S. has strong legal provisions that enable investors to take legal actions against abusive related-party transactions. For example, the Material Definitive Agreement has to be disclosed to the Securities Exchange Commission in the U.S. within four days of entering the agreement.

In India, Regulations related to RPTs are found in the Companies Act, 1956, the Indian Accounting Standard 18, the Auditors Report Order, and Clause 49 of the Listing Agreement. The Income Tax Act 1961 also contains provisions related to transfer pricing issues on such transactions. Recent changes in Income Tax (domestic transfer pricing), Companies Act, 2013 and Clause 49 are significant steps by regulators towards addressing risks arising from, that have until now been somewhat inadequately addressed, adverse related party transactions.

Changes introduced through Clause 49 and Companies Act, 2013 are an attempt to improve the corporate governance framework in India and respond well to the global practices in this regard. These changes have expanded definition of related party; coverage of type of such transactions; have brought in the concept of approval of audit committee or board of directors or the shareholders for all related party transactions. Implementation effectiveness would be result of application of these new regulations by various stakeholders. Anxiety of various stakeholders in this regard can be viewed through questions below that would require good understanding of the provisions to enable successful implementation.

Q1. Are requirements of 2013 Act, Accounting Standard and SEBI requirement with respect to related party aligned?

No. Following are some examples:

1. 2013 Act requires disclosure at the time of entering into contract or arrangement whereas accounting standard requires disclosure at the time of entering into a transaction

2. Clause 49 adds new class of related parties to the definition thereof given under the 2013 Act and includes close family members, fellow group entities, joint ventures of same third party and combinations thereof, which are not in accounting standard or the 2013 Act.

3. Revised clause 49 requires shareholders’ approval for all material related party transaction with no exception for transactions in ordinary course of business or at arms-length. Definition of material transactions differs.

In case of deviation, as a thumb rule, provision of the stricter of the applicable regulations shall be followed.

Q2:A corporate group has several foreign subsidiaries. Will provisions in relation to related parties apply to foreign companies as well?

A: The term ‘company’ as defined under the 2013 Act is a company incorporated under the Companies Act 2013 or any previous company law. Company incorporated under the relevant legislation of a foreign country is not a ‘company’ under the 2013Act. However, transactions by Indian company with a foreign company which is a subsidiary, associate, fellow subsidiary, joint venture of the same venturer or company under control of same promoter, would be covered based on understanding of combined reading of revised clause 49 and 2013 Act.

Q3: Provisions of 2013 Act are made effective from April 1, 2014 and those under clause 49 are effective from October 1, 2014 though early application is permitted. Operations of companies are ongoing and related party transactions are consummated. What assessment is required of the existing related party transactions, if any?

A. All companies are required to comply with requirements in relation RPTs, prospectively from the date of applicability of underlying regulation. Any default will be regarded as non-compliance and may attract penal provisions under the 2013 Act. Following actions are recommended to avoid any risk of default:

1. Companies should carefully review its related parties under the regulations and identify all existing and new related parties together with all existing and new contracts, arrangements and transactions etc. It shall develop its policy on materiality of related party transactions together with manner of dealing with them. Amongst other matters, the manner of dealings shall cover aspects relating to determination of key terms including arms-length price.

2. An immediate dialogue needs to be initiated with the Audit Committee to assess and confirm their expectations from the policy and review/approval protocols. A careful evaluation of existing and proposed RPTs is not unwarranted.

3. Company shall develop process and methodology and make necessary changes in systems and procedures adapting to the new set of regulations.

Q4. As regards the 2013 Act, many companies have expressed a view that if related party transactions are entered into ordinary course of business and are on arms-length basis then no board or shareholder’s approval is required. Which transactions will be regarded as ordinary course?

The phrase “ordinary course of business” is not defined under the Companies Act 2013 or rules made there under. It seems that the ordinary course of business will cover the usual transactions, customs and practices of a business and of a company. In its guidance to auditors, the Institute of Chartered Accountants of India has included following few examples of transactions that are considered outside the entity’s normal (or ordinary) course of business:

· Complex equity transactions, such as corporate restructurings or acquisitions.

· The leasing of premises or the rendering of management services by the entity to another party if no consideration is exchanged.

· Sales transactions with unusually large discounts or returns.

· Transactions with circular arrangements, for example, sales with a commitment to repurchase.

· Transactions under contracts whose terms are changed before expiry.

The assessment of whether transaction is in ordinary course of business is very subjective, judgemental and can vary on case-to-case basis giving consideration to nature of business and objects of the entity. The purpose of making such assessment is to determine whether the transaction is usual or customary to the company and/ or its line of business. Companies should consider variety of factors like size and volume of transactions, arms-length, frequency, purpose etc. to make this assessment.

Q5. Definition of related parties is very wide. What are key actions which management should take to ensure a robust process for identifying related parties?

Some of the key action areas which management can consider include:

Make all covered parties accountable towards making disclosure of their interest - for e.g. relevant information should be captured from vendor/customer at the time of including their names in the master vendor/client database. This might require workshops with the covered parties so that they understand and appreciate requirements fully.

Formalize the disclosure process through defined frequency, information and ownership

Conduct one time exercise to identify current spectrum of related parties

Set up a mechanism for ongoing updation of the related parties

Specify responsibility for disclosure in the event of change of interest and define responsibility for administering the process

Define frequency for updation of related parties’ repository on a periodic basis (apart from updating based on event based disclosures) along with approval matrix for making the changes and facility to maintain change logs.

Q6. In case of 2013 Act, is the board required to approve all related party transactions?

The 2013 Act prescribes that company needs approval of the Audit Committee on all related party transactions and subsequent modifications thereto. This is irrespective of whether they are in the ordinary course of business and consummated at arm’s length price or they are below prescribed thresholds. Further, for listed companies, Clause 49 prescribes audit committee approval for all related party transactions and shareholders approval of all material RPTs.

In case of a bank or a telecom company for example, directors/KMPs of a Bank may place fixed deposit with the Bank or directors/KMPs of telecom service provider may avail telecom services. Due to volume of similar transactions and impracticality to obtain prior approval from the board or shareholders for such large volume of transactions, many companies are of a considered view that lawmakers did not intend same to be required for transactions which are in ordinary course of business and are at arms-length. For normal transactions, if company has a well laid down policy framework which explicitly lays down terms of contract/transaction and which are approved by audit committee then a separate approval will be unwarranted for each such transaction. However, any modification/ transaction, which was not contemplated in the framework and approved by the Audit Committee in its initial approval, would require fresh approval of the Audit Committee.

Legal evaluation or a clarification from lawmakers would be necessary considering the difficulties such an approval might impose.

Q7. Companies normally engage in Master Service Agreements (MSA) to decide overall framework to avail services / goods. Will approvals be required at the time of entering MSA and also at the time of entering purchase orders?

Intention of regulators is that Audit Committee/Board approvals terms and conditions of the contract and transactions. MSA will satisfy definition of contract or arrangement and hence will require approvals specified. Specific approval of purchase orders or sub-contracts may not be required if MSA are not very general and lays down critical terms (nature of service, payment terms, pricing formula, timing and manner of revisions in terms etc.) of arrangement based on which sub-contracts or purchase orders are placed.

Q8. Many companies have existing contracts or MOUs or other arrangements entered into prior to introduction of these new regulations but the underlying transactions are likely to be operationalized in period after the introduction of the new regulations. Would such contracts require a review and approval of the audit committee/board or the shareholders, as the case may be, considering effective execution in the period after introduction of the new regulations?

MOUs are merely an understanding and not a definitive contract or arrangement. Clearly, these would require rigor of review under the new framework, prior to execution of definitive agreement. In relation to other contracts or arrangements covered above, although differing views might exist when evaluating the manner how regulations have been made, it would be improper to assume that such contracts or arrangements are not required to go through rigor of review now required considering these are operationalized only under the new regime of regulations.

Q9. What is meaning of arms-length? Is meaning of arms-length same as transfer pricing rules?

Arm’s length transaction means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. Most commonly used guidance in this regard under Income Tax provisions is given in International and domestic tax laws in context of transfer pricing regime. One may even refer to rules for registered valuers wherein valuation methodologies are prescribed for registered valuers. It should be noted that these guidance are not conclusive and have only persuasive value. One may consider various qualitative and quantitative assessments to determine arms-length.

For e.g. Let’s assume a bank who normal course of business provide 9% rate to their customers for placing fixed deposit for 2 year tenure. It offers 9.25% higher rate to all their group employees. One may argue that same is not at arms-length. Alternatively, one may argue that banks devise different strategy for various categories of customers. Employee population of entire group provide a significant customer base for the bank and hence providing higher rate is in accordance with business strategy and meets the criteria of arms-length. The arms-length assessment is subjective exercise and requires judgement after considering various parameters.

Q.10. Under the regulations, no member of the company is permitted to vote on a special resolution to approve any contract or arrangement which may be entered into by the company, if such a member is a related party. Does the bar from voting apply to “all” shareholders who are related parties or only those related parties who are conflicted?

In cases where shareholders are ‘related’ in some way or the other with the company (but are neither the intended transacting party nor interested in the transaction directly or indirectly that has been put up for approval) it will be inappropriate to interpret the law to say that all such shareholders are prohibited from voting. The principles of “majority of minority” voting must not result in any unfair advantage to the minority. However, plain reading of the regulations would suggest all related parties shall abstain from voting, whether related or unrelated. Consultations with legal experts might be required to ascertain intent of these provisions.

Concluding remarksImplementation is key and would require not only significant effort of the corporates but also of the regulators to continuously monitor the provisions and proactively provide necessary guidance to various stakeholders for smooth transition.